Breaking open the closed clearing systemsBreaking open the closed clearing systems

Winter 2015/2016Winter 2015/2016

The plan for a capital markets union is perhaps one of the most significant initiatives in the near 60-year history of the European project. Announced in February 2015 by Lord Hill, European Commissioner for Financial Stability, it is a flagship project for the current Commission under President Jean-Claude Juncker. The plan is ambitious – and threatens the current business models of some of the established infrastructure and many market participants – simply because Europe needs to address its underdeveloped equity markets, its measly bond issuance and an oversupply of post-trade infrastructure. More must be done to help small and medium-sized enterprises grow, particularly in the face of a declining count of listed companies. To spur economic growth, Europe needs stable, open, integrated, efficient and liquid markets for issuing financial instruments and for harnessing long-term savings to promote investment. One important aspect is open access in the clearing of securities and derivatives, which we examine in our special report.

Breaking open the closed clearing systemsBreaking open the closed clearing systems

Winter 2015/2016Winter 2015/2016

The plan for a capital markets union is perhaps one of the most significant initiatives in the near 60-year history of the European project. Announced in February 2015 by Lord Hill, European Commissioner for Financial Stability, it is a flagship project for the current Commission under President Jean-Claude Juncker. The plan is ambitious – and threatens the current business models of some of the established infrastructure and many market participants – simply because Europe needs to address its underdeveloped equity markets, its measly bond issuance and an oversupply of post-trade infrastructure. More must be done to help small and medium-sized enterprises grow, particularly in the face of a declining count of listed companies. To spur economic growth, Europe needs stable, open, integrated, efficient and liquid markets for issuing financial instruments and for harnessing long-term savings to promote investment. One important aspect is open access in the clearing of securities and derivatives, which we examine in our special report.

Competition among European trading venues, instigated in 2007 by the Markets in Financial Instruments Directive (MiFID) was a welcome first step. Set to take effect from January 3, 2018 (folllowing a 12-month deferral announced by the European Commission in February 2016) are significantly more comprehensive and complex reforms, as the existing legal framework is replaced by a new Directive, MiFID II – together with a Regulation, MiFIR, which deals with measures such as regulatory and technical standards and which will have direct legal effect, without the need for implementation into national law. The reforms provide for harmonized regulation across the 31 member states of the European Economic Area – the 28 EU member states plus Iceland, Norway and Liechtenstein.

The introduction via MiFID I of the multilateral trading facility (MTF) opened up the equity trading markets in Europe – spurring competition among the traditional stock exchanges in the face of these alternative trading venues. Very quickly, they challenged the often national near-monopolies held by stock exchanges and attracted new pools of liquidity by competing on speed of trade execution and cost of trading and clearing. MiFID II introduces a third category of trading venue, the organized trading facility (OTF), for bonds, structured finance products, emission allowances and derivatives.

The rewriting of the MiFID legislation will open the floodgates to competition among clearing houses in all asset classes. Exchanges have traditionally structured their central counterparty (CCP) clearing houses in a vertical silo, requiring trades on their exchange to be cleared by their own CCP. The new rules will break the closed systems by requiring open access in both directions: access of CCPs to exchanges and access of exchanges to CCPs, presenting a new environment which will have the greatest impact on derivatives trading and clearing.

Open access and interoperability

Open access allows the two parties to a trade to pick from a choice of CCPs that have gained access to the trading venue, in addition to the trading venue's own clearing house.

However, open access is only half of what is needed. The other half is interoperability between clearing houses that clear for the same trading venue. Interoperability between two CCPs is needed in order for each party to a trade to be able to use a different CCP.

Open access is not a new concept. In Europe, it has become commonplace for cash equities, as a consequence of the competition resulting from the expansion in trading venues. With firms able to trade a given line of stock on a variety of platforms, they need their CCP of choice to have access across the range of venues they trade on. In order for competition among trading venues to be efficient, open access arrangements become essential. Coming up...

Leading the way in the wholesale adoption of open access were the pan-European MTFs – BATS in July 2011 (prior to its merger with Chi-X) gave access to three CCPs in addition to the one it initially appointed, after regulators were satisfied with arrangements put in place to manage inter-CCP risks. By January 2012, Chi-X, Turquoise and UBS MTF also made available to their trading firms a choice of multiple CCPs. In November 2013, Aquis became the first MTF to appoint several interoperating CCPs at launch – EuroCCP in the Netherlands (then known as EMCF), LCH.Clearnet in the UK and Swiss-based SIX x-clear.

"For cash equities, open access and interoperability have gone hand-in-hand," says Diana Chan, CEO of EuroCCP, the largest pan-european clearing house for equities. "Early on, the traditional exchanges entered the space with cooperative clearing arrangements. Each exchange's CCP would clear the trades their own members execute on the other exchange, so that the trading firms do not need to establish an additional relationship with the other exchange's CCP. An example is the 2001 arrangement between LCH and x-clear with their joint access to Virt-x and SWX, the Swiss exchange." Such reciprocal arrangements were constructed as one CCP being the member of the other in a 'sub-CCP' model, acting as an intermediary for its own members.

These early arrangements were followed by a peer-to-peer model whereby CCPs began to compete with each other. "The clearing and settlement industry's 2006 Code of Conduct, presented to Commissioner McCreevy, defines how access and interoperability could work under competitive clearing and led to the 'version 2.0' interoperability model that we have today," says Ms Chan.

In the first half of 2015, 65% of all European equity trades (including Electronic Order Book, Off Order Book, and Dark Pool) were eligible for clearing through functioning or announced interoperability arrangements, principally those executed on BATS Chi-X, Turquoise, the Nasdaq markets, LSE, SIX Swiss Exchange and Oslo Børs. However, several of the traditional exchanges, including the major markets of Germany, Euronext, Italy and Spain, retain a closed system.

A current wave of expansion of interoperability arrangements sees Nasdaq Nordic, previously cleared only by EuroCCP, give access to LCH.Clearnet from November 23, 2015 and to SIX x-clear from March 29, 2016. For LSE and SIX Swiss Exchange, interoperability arrangements have long operated between their respective clearing houses. In May 2014, LSE announced that it will allow customers to clear trades with EuroCCP – going on to defer the planned March 2015 implementation of arrangements until October 26, 2015. SIX Swiss Exchange made a similar announcement in June 2015 and, subject to completion of testing, is due to give access to EuroCCP from March 28, 2016. Just one market is holding out from making an announcement that it will be cleared by all three interoperating CCPs: Oslo Børs. The exchange issued a statement to us, noting that it is constantly working on changes affecting market infrastructure – and pays particular attention to customer needs, operational risk, increased customer cost and collateral needs, along with an overarching policy of ensuring that the size of the infrastructure is proportional to the size of the market.

Even before gaining access to LSE and SIX Swiss Exchange – which together accounted for 15% of all European equity trades in the first half of 2015 – EuroCCP has become a major force in European equities clearing, having built a market share of some 40% of the entire market and close to 70% on platforms where it competes against SIX x-clear and LCH.Clearnet. Owned by ABN AMRO Clearing Bank, BATS Chi-X Europe, Nasdaq and The Depository Trust & Clearing Corporation (DTCC) since its 2013 merger with EMCF, the company clears equities across 18 national markets – 17 in Europe along with the modest activity in US stocks traded on MTFs – eliminating, through netting, over 99% of trades for settlement.

Pros and cons

+ Open access will spur more competition among CCPs, which should drive down clearing costs and encourage innovation and improvement in service levels. Banks and brokers will be free to pick just a handful of clearing houses and thus limit the upfront technology investment and funding of default pools across a multitude of CCPs, while also benefiting from netting – offsetting trading positions to reduce margin and collateral requirements. It will facilitate better risk management through netting and portfolio margining and is likely to create deeper pools of liquidity.

– Open access makes for more complex operations within a CCP. Several operators of vertical silos have voiced concerns that open access in clearing certain derivatives is a threat to their intellectual property, arguing it would stifle innovation for new products among exchanges.

– Interoperability has run smoothly for cash equities and fixed income. But for derivatives, where the exposures are that much greater, interoperability presents a significant, potential systemic risk. The April 17, 2015 representation letter to ESMA from Athens Exchange, Bolsas y Mercados Espaņoles, Eurex, Euronext, Holland Clearing House, ICE and London Metals Exchange stated: "forcing the interconnectedness of systemically important financial market infrastructures in derivatives poses a threat to market stability, especially in distressed market conditions".

While open access and interoperability in cash equities are the result of competition among trading venues and commercial needs, the clearing of derivatives is a very different ball game. This asset class is generally not fungible, with instruments often unique to an exchange that has claims to their intellectual property rights, presenting a significant obstacle for a third-party clearing house to enter into competition with the incumbent CCP that is under the same ownership as the exchange. Here, open access is being commanded by regulation – something which has divided opinion among exchanges.

The commercial dynamics of open access vary considerably between equities and derivatives. Competition has driven down the cost of clearing equities by 80 to 90%, thus putting a hefty dent in the profitability of equity clearing. Several CCPs which are yet to open up to full competition are, understandably, looking to protect their revenues from attrition by delaying the day of reckoning. Unless an equity CCP is subsidized from its group's derivatives clearing arm, its viability under competition may be called into question. "A national exchange might need to decide whether its own equities CCP gives it a competitive advantage and whether clearing equities is worth the financial investment and use of management bandwidth," notes Ms Chan.

Derivatives clearing is very profitable and faces little competition where, in contrast to equities, clearing can be a strategic differentiator. The exchange operator, with intellectual property rights over an index, typically claims such rights over derivatives which have the index as underlying. "There's something like a 10% success rate for new derivatives products," notes Ms Chan. "The incumbent CCP needs to do all the work to develop some ten new products for every one that will fly, so it's understandable that it is reluctant to allow another CCP to compete in clearing only the one profitable product." Likewise, a CCP owned by a successful derivatives exchange may be reluctant to give access to a trading venue which offers contracts that compete with its parent.

A debate is raging between two camps. On the one hand, EuroCCP, ICAP, LSE, Nasdaq and SIX welcome open access. On the other hand, Deutsche Börse and US-headquartered CME Group and Intercontinental Exchange (ICE) are staunch opponents.

The European post-trade infrastructure is fragmented and open access is seemingly a fait accompli. The principle forms part of the Level 1 measures for MiFID II – the framework legislation proposed by the European Commission and adopted by the Council and Parliament – and its removal would require the entire legislative process to be restarted. Under the proposed rules, access to a clearing house will not be unfettered. It is to be limited to regulated traders meeting specified minimum criteria, for contracts which have 'economic equivalence' – which is defined broadly, leaving the onus on a clearing house to show a difference between contracts that warrants denial of access.

The legislative process is currently in the Level 2 phase – entailing more detailed delegated acts, drafted by the Commission with advice from the European Securities Markets Authority (ESMA). This entails the regulatory body drafting a series of standards – technical standards, regulatory technical standards and implementing technical standards – for endorsement or amendment by the Commission. ESMA published its final technical standards on September 28, 2015.

In parallel with the move to open access, standardized OTC derivatives are set to become subject to mandatory clearing through a central counterparty under EMIR. While its implementation timetable has been put back multiple times, and at the outset affects only interest rate swaps and clearing members, it will place an added burden on market participants to gather and submit vast quantities of data about their trading activity.

Case study:Live interoperability for derivatives

Oslo Børs and London Stock Exchange operate the only live interoperability arrangement for exchange-traded derivatives. The two exchanges signed a strategic partnership agreement in March 2009. In December that year, they launched a fully-linked trading and clearing model for derivatives, with a centralized orderbook for each product which can be traded on either Oslo Børs or LSE's Derivatives Market, with central counterparty clearing through LCH.Clearnet or through Oslo Clearing or its parent SIX x-clear. Dealers benefit from ease of access and a central pool of liquidity. Oslo Børs informs us that they have no plans for further interoperability arrangements for derivatives.

"Interoperability presents a potential systemic risk, the risk of default of the other CCP, which is the reason why we collect collateral from each other," notes Christian Sjøberg, CEO of Oslo Clearing ASA. "Interoperability for derivatives follows the same guidelines as for equities, which include normal margining of each other, concentration add-ons, etc. The additional risk components for derivatives arise from the need to harmonize payment flows derived from derivatives, such as premium, mark-to-market, and exercise. This is done through harmonization of the product definition, so we receive money the same day as we pay out to customers and vice versa.

Open Access – Opening markets, opening choice

As the deadline for the implementation of MiFID II draws ever closer, industry eyes are focusing on the many implications of the sweeping European legislation. Chief amongst these, certainly for the tightly controlled world of European derivatives trading and clearing, is Open Access – the collective term for new provisions designed to provide investors with true choice in the market.

Open access to any market, from labour and intellectual property to food and industrial goods, lies at the heart of the philosophical approach to the EU single market. Financial markets are no exception, and users will benefit when they too are opened in a fair and transparent way.

The clock is ticking on the implementation of MiFID II and reforms set to transform the European financial landscape. Reforms that will not only deliver new competition, transparency and clarity, but form the foundation for a capital markets union in Europe. That may sound dramatic but it enshrines the principle of allowing investors to choose where to trade and clear their products, by preventing exchanges and clearing houses from operating a "closed" silo model, tying the trading, clearing and licensing of products to a specific venue.

The power of competition

Today's challenge bears a remarkable resemblance to 2007, when European exchanges enjoyed a virtual monopoly on the trading of shares. The revolution brought about by MiFID I, the EU's landmark piece of legislation, introducing competition to equity trading, made for difficult reading for Europe's exchanges. However, the result for customers and investors was transformational: lower trading prices, reduced spreads, faster and more resilient technology, and a fundamental rebalancing of the relationship between the providers of infrastructure and its users. That's the power of competition.

Industry support

In an open letter issued last summer, the vast majority of the financial services industry voiced its support for a more open model, including the world's largest asset managers, investors, major sell-side participants and trade associations. Regulators too have voiced their opinion, identifying fair and open access as an important foundation in the building of safe and efficient markets.

Interoperability: a clear distinction

The difference between the two is important and should not be confused. Open Access means ensuring non-discriminatory access to trading and clearing infrastructures. In short, trading venues should have non-discriminatory access to CCPs (central counterparties) – allowing investors to trade on alternative platforms and benefit from lower trading fees across asset classes. Similarly, CCPs should have non-discriminatory access to trading venues – offering investors the opportunity to benefit from reduction/netting of their clearing margin within an aggregated and enhanced liquidity pool.

Interoperability means allowing products traded on separate venues to be fully fungible. In other words, it obliges clearing houses to interconnect, sharing their open interest pool and helping market participants to reduce costs by netting and cross-margining trades taking place on different venues. This forces CCPs to swap collateral amongst themselves, creating a systemic link between each other. Crucially, we do not believe and have not called for interoperability to be mandated, particularly for derivatives.

A record of delivery

The Open Access model works and at LSEG we've been applying it to our business for the benefit of customers for some years. For instance, Turquoise, and any work we might undertake with Plato is a great example of our Open Access approach: partnering with customers to deliver the right solution. It's an approach we've adopted with LCH.Clearnet as well to great effect.

We're also open to working with our competitors if it produces the right result for our customers. In August, FTSE Russell and CME Group signed an agreement that will see CME Group list derivatives contracts based on Russell indexes. It's a similar approach that we've adopted in recent deals with BOAT and DTCC – both competitors – to deliver enhanced products for customers. In technology, we have provided our world-leading MillenniumIT offering to more than 40 exchanges and venues around the world.

Change is coming

Genuine, far-reaching change is coming to the European derivatives market. Change that has the unequivocal backing of the vast majority of participants, including the world's largest asset managers, investors, sell-side firms and trade associations. More open markets not only bring economic benefits to customers, they also increase transparency and safety.

"The biggest risk however is how to manage the closing out of a big position with a limited number of market players. This requires further stress test add-ons in the margining. However, with more and more collateral, this becomes negative from a competitive perspective."

Mr Sjøberg proposes a better model, with CCPs and market participants pre-agreeing portability – so that, if one CCP fails, all its customers would automatically be moved to the other CCP. "Such a model would reduce collateral requirements," he tells us, "but would require operational readiness for customers and incur some fixed cost for being an inactive member, including membership fee and minimum funding contribution."

While interoperability arrangements would produce an ideal environment in which a trader has a free choice of CCP, open access can still take off without interoperability. A challenger CCP with a price advantage, perhaps also offering a fee holiday for a few weeks, would only have to attract two firms with a large volume of trades with each other to get going. Of course, the two firms would both have to become members of the challenger CCP and at the same time remain as members of the incumbent CCP to clear trades they have with all the other firms. But if motivated to do so, the challenger CCP would have a good chance of establishing a book of business on which it can expand its client roster and grow rapidly.

The global perspective

In the US, many CCPs have cross-margining arrangements covering fixed-income instruments, futures and options. These include DTCC's Fixed Income Clearing Corporation, ICE Clear Europe, ICE Clear US, Options Clearing Corporation and CME Clearing. In 2000, CME Clearing and LCH.Clearnet established a cross-margining arrangement for short-term interest rate contracts, but this was terminated in 2010 in the face of increased maintenance costs. Competition in the clearing of exchange-traded derivatives has emerged with NYSE Liffe taking on CME.

Across Asia Pacific, equity markets are dominated by vertical silos for which there is no foreseeable prospect of open access or interoperability. CCPs for derivatives are being built – to meet the call of global regulators for central clearing – with the region currently accounting for a 15% share of the $600 million global OTC derivatives market, according to research and consulting firm Celent. Regulators are gradually mandating the use of domestic clearing houses for derivatives which track domestic instruments or indexes, or are otherwise of systemic importance to the local economy. Yet the bulk of OTC derivatives trades in the region are cross-border, denominated in Singapore dollar, US dollar or euro, for which the likes of CME, ICE and LCH.Clearnet are unlikely to face serious competition from local CCPs.

Deutsche Börse is steadily expanding in Asia. The operator of Eurex and the Frankfurt Stock Exchange has links with the Korea Exchange and the Taiwan Futures Exchange for trading index derivatives outside of the local time zones and is set to launch Eurex Clearing Asia in 2016, following regulatory approval from the Monetary Authority of Singapore. Eurex plans to operate its own derivatives exchange in Singapore, having submitted an application to the regulator in May 2015.

Rival ICE, which acquired Singapore Mercantile Exchange in 2013, experienced some delay before its November 2015 launch of the ICE Futures Singapore exchange. This offers regional hedging opportunities across financial derivatives, but not commodities after a legal challenge by a Chinese rival. ICE Clear Singapore will act as CCP.

The way forward

Expansion of open access to clearing houses will continue to meet resistance from those trading venues which do not see it as beneficial to their business, but firms active in cross-border trading will welcome competition among CCPs where this drives down the high clearing costs which impede their ability to trade. The best way to push ahead is for members to put pressure on the trading venues. "It is clearing members – and ultimately all market participants – which bear the high clearing costs charged by CCPs unwilling to compete," says Ms Chan.

With the regulatory mandate in Europe, along with trading firms' greater attention to costs and desire for choice, we can expect to see a continued drive towards open access – with a steady expansion of the current, restricted implementation of interoperability which keeps costs higher than would otherwise be necessary. This next phase will gradually eliminate multiple clearing, margining and settlement channels and is likely to be a precursor to consolidation among CCPs.

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Competition among European trading venues, instigated in 2007 by the Markets in Financial Instruments Directive (MiFID) was a welcome first step. Set to take effect from January 3, 2018 (folllowing a 12-month deferral announced by the European Commission in February 2016) are significantly more comprehensive and complex reforms, as the existing legal framework is replaced by a new Directive, MiFID II – together with a Regulation, MiFIR, which deals with measures such as regulatory and technical standards and which will have direct legal effect, without the need for implementation into national law. The reforms provide for harmonized regulation across the 31 member states of the European Economic Area – the 28 EU member states plus Iceland, Norway and Liechtenstein.

The introduction via MiFID I of the multilateral trading facility (MTF) opened up the equity trading markets in Europe – spurring competition among the traditional stock exchanges in the face of these alternative trading venues. Very quickly, they challenged the often national near-monopolies held by stock exchanges and attracted new pools of liquidity by competing on speed of trade execution and cost of trading and clearing. MiFID II introduces a third category of trading venue, the organized trading facility (OTF), for bonds, structured finance products, emission allowances and derivatives.

The rewriting of the MiFID legislation will open the floodgates to competition among clearing houses in all asset classes. Exchanges have traditionally structured their central counterparty (CCP) clearing houses in a vertical silo, requiring trades on their exchange to be cleared by their own CCP. The new rules will break the closed systems by requiring open access in both directions: access of CCPs to exchanges and access of exchanges to CCPs, presenting a new environment which will have the greatest impact on derivatives trading and clearing.

Open access and interoperability

Open access allows the two parties to a trade to pick from a choice of CCPs that have gained access to the trading venue, in addition to the trading venue's own clearing house.

However, open access is only half of what is needed. The other half is interoperability between clearing houses that clear for the same trading venue. Interoperability between two CCPs is needed in order for each party to a trade to be able to use a different CCP.

Open access is not a new concept. In Europe, it has become commonplace for cash equities, as a consequence of the competition resulting from the expansion in trading venues. With firms able to trade a given line of stock on a variety of platforms, they need their CCP of choice to have access across the range of venues they trade on. In order for competition among trading venues to be efficient, open access arrangements become essential. Coming up...

Leading the way in the wholesale adoption of open access were the pan-European MTFs – BATS in July 2011 (prior to its merger with Chi-X) gave access to three CCPs in addition to the one it initially appointed, after regulators were satisfied with arrangements put in place to manage inter-CCP risks. By January 2012, Chi-X, Turquoise and UBS MTF also made available to their trading firms a choice of multiple CCPs. In November 2013, Aquis became the first MTF to appoint several interoperating CCPs at launch – EuroCCP in the Netherlands (then known as EMCF), LCH.Clearnet in the UK and Swiss-based SIX x-clear.

"For cash equities, open access and interoperability have gone hand-in-hand," says Diana Chan, CEO of EuroCCP, the largest pan-european clearing house for equities. "Early on, the traditional exchanges entered the space with cooperative clearing arrangements. Each exchange's CCP would clear the trades their own members execute on the other exchange, so that the trading firms do not need to establish an additional relationship with the other exchange's CCP. An example is the 2001 arrangement between LCH and x-clear with their joint access to Virt-x and SWX, the Swiss exchange." Such reciprocal arrangements were constructed as one CCP being the member of the other in a 'sub-CCP' model, acting as an intermediary for its own members.

These early arrangements were followed by a peer-to-peer model whereby CCPs began to compete with each other. "The clearing and settlement industry's 2006 Code of Conduct, presented to Commissioner McCreevy, defines how access and interoperability could work under competitive clearing and led to the 'version 2.0' interoperability model that we have today," says Ms Chan.

In the first half of 2015, 65% of all European equity trades (including Electronic Order Book, Off Order Book, and Dark Pool) were eligible for clearing through functioning or announced interoperability arrangements, principally those executed on BATS Chi-X, Turquoise, the Nasdaq markets, LSE, SIX Swiss Exchange and Oslo Børs. However, several of the traditional exchanges, including the major markets of Germany, Euronext, Italy and Spain, retain a closed system.

A current wave of expansion of interoperability arrangements sees Nasdaq Nordic, previously cleared only by EuroCCP, give access to LCH.Clearnet from November 23, 2015 and to SIX x-clear from March 29, 2016. For LSE and SIX Swiss Exchange, interoperability arrangements have long operated between their respective clearing houses. In May 2014, LSE announced that it will allow customers to clear trades with EuroCCP – going on to defer the planned March 2015 implementation of arrangements until October 26, 2015. SIX Swiss Exchange made a similar announcement in June 2015 and, subject to completion of testing, is due to give access to EuroCCP from March 28, 2016. Just one market is holding out from making an announcement that it will be cleared by all three interoperating CCPs: Oslo Børs. The exchange issued a statement to us, noting that it is constantly working on changes affecting market infrastructure – and pays particular attention to customer needs, operational risk, increased customer cost and collateral needs, along with an overarching policy of ensuring that the size of the infrastructure is proportional to the size of the market.

Even before gaining access to LSE and SIX Swiss Exchange – which together accounted for 15% of all European equity trades in the first half of 2015 – EuroCCP has become a major force in European equities clearing, having built a market share of some 40% of the entire market and close to 70% on platforms where it competes against SIX x-clear and LCH.Clearnet. Owned by ABN AMRO Clearing Bank, BATS Chi-X Europe, Nasdaq and The Depository Trust & Clearing Corporation (DTCC) since its 2013 merger with EMCF, the company clears equities across 18 national markets – 17 in Europe along with the modest activity in US stocks traded on MTFs – eliminating, through netting, over 99% of trades for settlement.

Pros and cons

+ Open access will spur more competition among CCPs, which should drive down clearing costs and encourage innovation and improvement in service levels. Banks and brokers will be free to pick just a handful of clearing houses and thus limit the upfront technology investment and funding of default pools across a multitude of CCPs, while also benefiting from netting – offsetting trading positions to reduce margin and collateral requirements. It will facilitate better risk management through netting and portfolio margining and is likely to create deeper pools of liquidity.

– Open access makes for more complex operations within a CCP. Several operators of vertical silos have voiced concerns that open access in clearing certain derivatives is a threat to their intellectual property, arguing it would stifle innovation for new products among exchanges.

– Interoperability has run smoothly for cash equities and fixed income. But for derivatives, where the exposures are that much greater, interoperability presents a significant, potential systemic risk. The April 17, 2015 representation letter to ESMA from Athens Exchange, Bolsas y Mercados Espaņoles, Eurex, Euronext, Holland Clearing House, ICE and London Metals Exchange stated: "forcing the interconnectedness of systemically important financial market infrastructures in derivatives poses a threat to market stability, especially in distressed market conditions".

While open access and interoperability in cash equities are the result of competition among trading venues and commercial needs, the clearing of derivatives is a very different ball game. This asset class is generally not fungible, with instruments often unique to an exchange that has claims to their intellectual property rights, presenting a significant obstacle for a third-party clearing house to enter into competition with the incumbent CCP that is under the same ownership as the exchange. Here, open access is being commanded by regulation – something which has divided opinion among exchanges.

The commercial dynamics of open access vary considerably between equities and derivatives. Competition has driven down the cost of clearing equities by 80 to 90%, thus putting a hefty dent in the profitability of equity clearing. Several CCPs which are yet to open up to full competition are, understandably, looking to protect their revenues from attrition by delaying the day of reckoning. Unless an equity CCP is subsidized from its group's derivatives clearing arm, its viability under competition may be called into question. "A national exchange might need to decide whether its own equities CCP gives it a competitive advantage and whether clearing equities is worth the financial investment and use of management bandwidth," notes Ms Chan.

Derivatives clearing is very profitable and faces little competition where, in contrast to equities, clearing can be a strategic differentiator. The exchange operator, with intellectual property rights over an index, typically claims such rights over derivatives which have the index as underlying. "There's something like a 10% success rate for new derivatives products," notes Ms Chan. "The incumbent CCP needs to do all the work to develop some ten new products for every one that will fly, so it's understandable that it is reluctant to allow another CCP to compete in clearing only the one profitable product." Likewise, a CCP owned by a successful derivatives exchange may be reluctant to give access to a trading venue which offers contracts that compete with its parent.

A debate is raging between two camps. On the one hand, EuroCCP, ICAP, LSE, Nasdaq and SIX welcome open access. On the other hand, Deutsche Börse and US-headquartered CME Group and Intercontinental Exchange (ICE) are staunch opponents.

The European post-trade infrastructure is fragmented and open access is seemingly a fait accompli. The principle forms part of the Level 1 measures for MiFID II – the framework legislation proposed by the European Commission and adopted by the Council and Parliament – and its removal would require the entire legislative process to be restarted. Under the proposed rules, access to a clearing house will not be unfettered. It is to be limited to regulated traders meeting specified minimum criteria, for contracts which have 'economic equivalence' – which is defined broadly, leaving the onus on a clearing house to show a difference between contracts that warrants denial of access.

The legislative process is currently in the Level 2 phase – entailing more detailed delegated acts, drafted by the Commission with advice from the European Securities Markets Authority (ESMA). This entails the regulatory body drafting a series of standards – technical standards, regulatory technical standards and implementing technical standards – for endorsement or amendment by the Commission. ESMA published its final technical standards on September 28, 2015.

In parallel with the move to open access, standardized OTC derivatives are set to become subject to mandatory clearing through a central counterparty under EMIR. While its implementation timetable has been put back multiple times, and at the outset affects only interest rate swaps and clearing members, it will place an added burden on market participants to gather and submit vast quantities of data about their trading activity.

Case study:Live interoperability for derivatives

Oslo Børs and London Stock Exchange operate the only live interoperability arrangement for exchange-traded derivatives. The two exchanges signed a strategic partnership agreement in March 2009. In December that year, they launched a fully-linked trading and clearing model for derivatives, with a centralized orderbook for each product which can be traded on either Oslo Børs or LSE's Derivatives Market, with central counterparty clearing through LCH.Clearnet or through Oslo Clearing or its parent SIX x-clear. Dealers benefit from ease of access and a central pool of liquidity. Oslo Børs informs us that they have no plans for further interoperability arrangements for derivatives.

"Interoperability presents a potential systemic risk, the risk of default of the other CCP, which is the reason why we collect collateral from each other," notes Christian Sjøberg, CEO of Oslo Clearing ASA. "Interoperability for derivatives follows the same guidelines as for equities, which include normal margining of each other, concentration add-ons, etc. The additional risk components for derivatives arise from the need to harmonize payment flows derived from derivatives, such as premium, mark-to-market, and exercise. This is done through harmonization of the product definition, so we receive money the same day as we pay out to customers and vice versa.

Open Access – Opening markets, opening choice

As the deadline for the implementation of MiFID II draws ever closer, industry eyes are focusing on the many implications of the sweeping European legislation. Chief amongst these, certainly for the tightly controlled world of European derivatives trading and clearing, is Open Access – the collective term for new provisions designed to provide investors with true choice in the market.

Open access to any market, from labour and intellectual property to food and industrial goods, lies at the heart of the philosophical approach to the EU single market. Financial markets are no exception, and users will benefit when they too are opened in a fair and transparent way.

The clock is ticking on the implementation of MiFID II and reforms set to transform the European financial landscape. Reforms that will not only deliver new competition, transparency and clarity, but form the foundation for a capital markets union in Europe. That may sound dramatic but it enshrines the principle of allowing investors to choose where to trade and clear their products, by preventing exchanges and clearing houses from operating a "closed" silo model, tying the trading, clearing and licensing of products to a specific venue.

The power of competition

Today's challenge bears a remarkable resemblance to 2007, when European exchanges enjoyed a virtual monopoly on the trading of shares. The revolution brought about by MiFID I, the EU's landmark piece of legislation, introducing competition to equity trading, made for difficult reading for Europe's exchanges. However, the result for customers and investors was transformational: lower trading prices, reduced spreads, faster and more resilient technology, and a fundamental rebalancing of the relationship between the providers of infrastructure and its users. That's the power of competition.

Industry support

In an open letter issued last summer, the vast majority of the financial services industry voiced its support for a more open model, including the world's largest asset managers, investors, major sell-side participants and trade associations. Regulators too have voiced their opinion, identifying fair and open access as an important foundation in the building of safe and efficient markets.

Interoperability: a clear distinction

The difference between the two is important and should not be confused. Open Access means ensuring non-discriminatory access to trading and clearing infrastructures. In short, trading venues should have non-discriminatory access to CCPs (central counterparties) – allowing investors to trade on alternative platforms and benefit from lower trading fees across asset classes. Similarly, CCPs should have non-discriminatory access to trading venues – offering investors the opportunity to benefit from reduction/netting of their clearing margin within an aggregated and enhanced liquidity pool.

Interoperability means allowing products traded on separate venues to be fully fungible. In other words, it obliges clearing houses to interconnect, sharing their open interest pool and helping market participants to reduce costs by netting and cross-margining trades taking place on different venues. This forces CCPs to swap collateral amongst themselves, creating a systemic link between each other. Crucially, we do not believe and have not called for interoperability to be mandated, particularly for derivatives.

A record of delivery

The Open Access model works and at LSEG we've been applying it to our business for the benefit of customers for some years. For instance, Turquoise, and any work we might undertake with Plato is a great example of our Open Access approach: partnering with customers to deliver the right solution. It's an approach we've adopted with LCH.Clearnet as well to great effect.

We're also open to working with our competitors if it produces the right result for our customers. In August, FTSE Russell and CME Group signed an agreement that will see CME Group list derivatives contracts based on Russell indexes. It's a similar approach that we've adopted in recent deals with BOAT and DTCC – both competitors – to deliver enhanced products for customers. In technology, we have provided our world-leading MillenniumIT offering to more than 40 exchanges and venues around the world.

Change is coming

Genuine, far-reaching change is coming to the European derivatives market. Change that has the unequivocal backing of the vast majority of participants, including the world's largest asset managers, investors, sell-side firms and trade associations. More open markets not only bring economic benefits to customers, they also increase transparency and safety.

"The biggest risk however is how to manage the closing out of a big position with a limited number of market players. This requires further stress test add-ons in the margining. However, with more and more collateral, this becomes negative from a competitive perspective."

Mr Sjøberg proposes a better model, with CCPs and market participants pre-agreeing portability – so that, if one CCP fails, all its customers would automatically be moved to the other CCP. "Such a model would reduce collateral requirements," he tells us, "but would require operational readiness for customers and incur some fixed cost for being an inactive member, including membership fee and minimum funding contribution."

While interoperability arrangements would produce an ideal environment in which a trader has a free choice of CCP, open access can still take off without interoperability. A challenger CCP with a price advantage, perhaps also offering a fee holiday for a few weeks, would only have to attract two firms with a large volume of trades with each other to get going. Of course, the two firms would both have to become members of the challenger CCP and at the same time remain as members of the incumbent CCP to clear trades they have with all the other firms. But if motivated to do so, the challenger CCP would have a good chance of establishing a book of business on which it can expand its client roster and grow rapidly.

The global perspective

In the US, many CCPs have cross-margining arrangements covering fixed-income instruments, futures and options. These include DTCC's Fixed Income Clearing Corporation, ICE Clear Europe, ICE Clear US, Options Clearing Corporation and CME Clearing. In 2000, CME Clearing and LCH.Clearnet established a cross-margining arrangement for short-term interest rate contracts, but this was terminated in 2010 in the face of increased maintenance costs. Competition in the clearing of exchange-traded derivatives has emerged with NYSE Liffe taking on CME.

Across Asia Pacific, equity markets are dominated by vertical silos for which there is no foreseeable prospect of open access or interoperability. CCPs for derivatives are being built – to meet the call of global regulators for central clearing – with the region currently accounting for a 15% share of the $600 million global OTC derivatives market, according to research and consulting firm Celent. Regulators are gradually mandating the use of domestic clearing houses for derivatives which track domestic instruments or indexes, or are otherwise of systemic importance to the local economy. Yet the bulk of OTC derivatives trades in the region are cross-border, denominated in Singapore dollar, US dollar or euro, for which the likes of CME, ICE and LCH.Clearnet are unlikely to face serious competition from local CCPs.

Deutsche Börse is steadily expanding in Asia. The operator of Eurex and the Frankfurt Stock Exchange has links with the Korea Exchange and the Taiwan Futures Exchange for trading index derivatives outside of the local time zones and is set to launch Eurex Clearing Asia in 2016, following regulatory approval from the Monetary Authority of Singapore. Eurex plans to operate its own derivatives exchange in Singapore, having submitted an application to the regulator in May 2015.

Rival ICE, which acquired Singapore Mercantile Exchange in 2013, experienced some delay before its November 2015 launch of the ICE Futures Singapore exchange. This offers regional hedging opportunities across financial derivatives, but not commodities after a legal challenge by a Chinese rival. ICE Clear Singapore will act as CCP.

The way forward

Expansion of open access to clearing houses will continue to meet resistance from those trading venues which do not see it as beneficial to their business, but firms active in cross-border trading will welcome competition among CCPs where this drives down the high clearing costs which impede their ability to trade. The best way to push ahead is for members to put pressure on the trading venues. "It is clearing members – and ultimately all market participants – which bear the high clearing costs charged by CCPs unwilling to compete," says Ms Chan.

With the regulatory mandate in Europe, along with trading firms' greater attention to costs and desire for choice, we can expect to see a continued drive towards open access – with a steady expansion of the current, restricted implementation of interoperability which keeps costs higher than would otherwise be necessary. This next phase will gradually eliminate multiple clearing, margining and settlement channels and is likely to be a precursor to consolidation among CCPs.